Tuesday, January 27, 2009

Quoting an email [from Paul Krugman], economists who "have spent their entire careers on
equilibrium business cycle theory are now discovering that, in effect, they
invested their savings with Bernie Madoff." I think that's right, and as they
come to this realization, we can expect these economists to flail about defending the
indefensible, they will be quite vicious at times, and in their panic to defend
the work they have spent their lives on, they may not be very careful about the arguments they make. I
don't know if the defenders of the classical faith have come to this realization
yet, at least beyond the subconscious level, and the profession will most likely
move in the same old direction for awhile due to research inertia if nothing else. But I
think what has happened will have a much bigger impact on the profession and the
models it uses to describe the world than most economists currently realize:

A Dark Age of macroeconomics (wonkish), by Paul Krugman:
Brad DeLong is upset about the stuff coming out of Chicago these days — and
understandably so. First
Eugene Fama, now
John Cochrane, have made the claim that debt-financed government spending
necessarily crowds out an equal amount of private spending, even if the economy
is depressed — and they claim this not as an empirical result, not as the
prediction of some model, but as the ineluctable implication of an accounting
identity.

There has been a tendency, on the part of other economists, to try to provide
cover — to claim that Fama and Cochrane said something more sophisticated than
they did. But if you read the original essays, there’s no ambiguity — it’s pure
Say’s Law, pure “Treasury view”, in each case. Here’s Fama... And here’s
Cochrane...

There’s no ambiguity in either case: both Fama and Cochrane are asserting
that desired savings are automatically converted into investment spending, and
that any government borrowing must come at the expense of investment — period.

What’s so mind-boggling about this is that it commits one of the most basic
fallacies in economics — interpreting an accounting identity as a behavioral
relationship. Yes, savings have to equal investment, but that’s not something
that mystically takes place, it’s because any discrepancy between desired
savings and desired investment causes something to happen that brings the two in
line. ... [A]fter a change in desired savings or investment..., if interest
rates are fixed, what happens is that GDP changes to make S and I equal.

That’s actually the point of one of the ways multiplier analysis is often
presented to freshmen. Here’s the
diagram...

In this picture savings plus taxes equal investment plus government spending,
the accounting identity that both Fama and Cochrane think vitiates fiscal policy
— but it doesn’t. An increase in G doesn’t reduce I one for one, it increases
GDP, which leads to higher S and T.

Now, you don’t have to accept this model as a picture of how the world works.
But you do have to accept that it shows the fallacy of arguing that the
savings-investment identity proves anything about the effectiveness of fiscal
policy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics.
Remember, what defined the Dark Ages wasn’t the fact that they were primitive —
the Bronze Age was primitive, too. What made the Dark Ages dark was the fact
that so much knowledge had been lost, that so much known to the Greeks and
Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the
economics profession. The knowledge that S=I doesn’t imply the Treasury view —
the general understanding that macroeconomics is more than supply and demand
plus the quantity equation — somehow got lost in much of the profession. I’m
tempted to go on and say something about being overrun by barbarians in the grip
of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

Given their understanding of macroeconomics, and I mean the basics not the
hard stuff, it's becoming a lot easier to understand how financial economists
missed the developing bubble and the effect it would have on the macroeconomy.
We specialize mightily in academic economics, people will work on very narrow
questions for their entire careers and become world class experts on that
question, but they tend to forget what they learned in other areas over time,
and they can't possibly keep up with developments outside their areas of
specialization. So we rely and depend upon the expertise of others to inform us
about areas in which we don't normally work. One thing I've learned from the current episode is
not to automatically trust that the most well-known economists in the field have
done due diligence before speaking out on an issue, even when that issue is of great public importance, or even to trust that they've thought very hard about the
problems they are speaking to. I used to think that, for the most part, the
name brands in the field would live up to their reputations, that they would
think hard about problems before speaking out in public, that they would provide
clarity and insight, but they haven't. In fact, in many cases they have
undermined their reputations and confused the issues. People have been
deferential in the past, myself included, and these people have been given
authority in the public discourse - even when they are demonstrably wrong their arguments
show up in the press as a "he said, she said" presentation. But, unfortunately
for the economics profession and for the public generally, the so called best
and brightest among us have not lived up to the responsibilities that come with the prominent positions that they hold.

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"A Dark Age of Macroeconomics"

Quoting an email [from Paul Krugman], economists who "have spent their entire careers on
equilibrium business cycle theory are now discovering that, in effect, they
invested their savings with Bernie Madoff." I think that's right, and as they
come to this realization, we can expect these economists to flail about defending the
indefensible, they will be quite vicious at times, and in their panic to defend
the work they have spent their lives on, they may not be very careful about the arguments they make. I
don't know if the defenders of the classical faith have come to this realization
yet, at least beyond the subconscious level, and the profession will most likely
move in the same old direction for awhile due to research inertia if nothing else. But I
think what has happened will have a much bigger impact on the profession and the
models it uses to describe the world than most economists currently realize:

A Dark Age of macroeconomics (wonkish), by Paul Krugman:
Brad DeLong is upset about the stuff coming out of Chicago these days — and
understandably so. First
Eugene Fama, now
John Cochrane, have made the claim that debt-financed government spending
necessarily crowds out an equal amount of private spending, even if the economy
is depressed — and they claim this not as an empirical result, not as the
prediction of some model, but as the ineluctable implication of an accounting
identity.

There has been a tendency, on the part of other economists, to try to provide
cover — to claim that Fama and Cochrane said something more sophisticated than
they did. But if you read the original essays, there’s no ambiguity — it’s pure
Say’s Law, pure “Treasury view”, in each case. Here’s Fama... And here’s
Cochrane...

There’s no ambiguity in either case: both Fama and Cochrane are asserting
that desired savings are automatically converted into investment spending, and
that any government borrowing must come at the expense of investment — period.

What’s so mind-boggling about this is that it commits one of the most basic
fallacies in economics — interpreting an accounting identity as a behavioral
relationship. Yes, savings have to equal investment, but that’s not something
that mystically takes place, it’s because any discrepancy between desired
savings and desired investment causes something to happen that brings the two in
line. ... [A]fter a change in desired savings or investment..., if interest
rates are fixed, what happens is that GDP changes to make S and I equal.

That’s actually the point of one of the ways multiplier analysis is often
presented to freshmen. Here’s the
diagram...

In this picture savings plus taxes equal investment plus government spending,
the accounting identity that both Fama and Cochrane think vitiates fiscal policy
— but it doesn’t. An increase in G doesn’t reduce I one for one, it increases
GDP, which leads to higher S and T.

Now, you don’t have to accept this model as a picture of how the world works.
But you do have to accept that it shows the fallacy of arguing that the
savings-investment identity proves anything about the effectiveness of fiscal
policy.

So how is it possible that distinguished professors believe otherwise?

The answer, I think, is that we’re living in a Dark Age of macroeconomics.
Remember, what defined the Dark Ages wasn’t the fact that they were primitive —
the Bronze Age was primitive, too. What made the Dark Ages dark was the fact
that so much knowledge had been lost, that so much known to the Greeks and
Romans had been forgotten by the barbarian kingdoms that followed.

And that’s what seems to have happened to macroeconomics in much of the
economics profession. The knowledge that S=I doesn’t imply the Treasury view —
the general understanding that macroeconomics is more than supply and demand
plus the quantity equation — somehow got lost in much of the profession. I’m
tempted to go on and say something about being overrun by barbarians in the grip
of an obscurantist faith, but I guess I won’t. Oh wait, I guess I just did.

Given their understanding of macroeconomics, and I mean the basics not the
hard stuff, it's becoming a lot easier to understand how financial economists
missed the developing bubble and the effect it would have on the macroeconomy.
We specialize mightily in academic economics, people will work on very narrow
questions for their entire careers and become world class experts on that
question, but they tend to forget what they learned in other areas over time,
and they can't possibly keep up with developments outside their areas of
specialization. So we rely and depend upon the expertise of others to inform us
about areas in which we don't normally work. One thing I've learned from the current episode is
not to automatically trust that the most well-known economists in the field have
done due diligence before speaking out on an issue, even when that issue is of great public importance, or even to trust that they've thought very hard about the
problems they are speaking to. I used to think that, for the most part, the
name brands in the field would live up to their reputations, that they would
think hard about problems before speaking out in public, that they would provide
clarity and insight, but they haven't. In fact, in many cases they have
undermined their reputations and confused the issues. People have been
deferential in the past, myself included, and these people have been given
authority in the public discourse - even when they are demonstrably wrong their arguments
show up in the press as a "he said, she said" presentation. But, unfortunately
for the economics profession and for the public generally, the so called best
and brightest among us have not lived up to the responsibilities that come with the prominent positions that they hold.